1. Field of the Invention
The present invention relates to a method of creating an index of residual values for leased assets, transferring residual value risk, and creating lease securitizations and, in particular, to a method of creating an index of residual values for leased vehicles and of transferring residual value risk and creating lease securitizations such as futures, options and insurance products in consideration of the index of residual values.
2. Description of the Related Art
Residual Value Risk.
Auto leasing has become quite common in the last 15 years. In the United States, currently about 30% of all new cars are financed through leasing. In lease financing, the auto is technically the property of the finance company, even though the lessee is driving the vehicle and otherwise has rights and responsibilities very similar to owning that same car.
Unlike traditional financing, where the purchaser assumes the risk of fluctuations in used car prices, a lease makes the finance company the primary party exposed to changes in market value. Thus, banks, automakers"" finance units, and other financial institutions have large risks relating to the market value of leased vehicles when they are returned at the ends of leases.
Although the resale value of a used car does not factor into traditional financing, it is very important in setting lease terms. For example, if a new year 2000 Toyota Camry has an initial cost of $20,000, Finance Company A might assume that its residual value would be $15,000 at the end of a three year lease. Finance Company B might assume that the same Camry would be worth $16,000 at the end of the same lease. Since Finance Company B assumes the vehicle will have a higher resale value, if the effective interest rates offered by both finance companies are the same, Company B will require a lower lease payment and obtain substantially more business than Company A.
Either finance company would have to wait until the end of the three-year lease to be sure of the final residual value and the exact profitability of that lease. If the actual residual value is $14,000, Company B will experience a residual value loss of $2,000. While $2,000 is immaterial for most finance companies, it is likely that similar overestimations of residual value were made on other vehicles of the same model. During times of intense competition, many finance companies have overestimated the residual values of large portions of the leases originated during an entire model year. In 1999, the Consumer Bankers Association estimated that banks lost money on about 75% of auto leases and that the average shortfall was $1,800 per car. Overestimates of residual value can cause unexpected losses of tens of millions of dollars for large finance companies. Many finance companies use residual value estimates from third parties, such as the Automobile Lease. Guide. However, these third party estimates are not guarantees and are subject to problems similar to any economic forecast.
If the actual residual value at the end of three years is over $16,000, Company B will not experience a loss on sale. However, because of the way most leases are structured, finance companies do not derive most of the benefit when residual values are higher than expected. The auto lessee usually has the option of purchasing the vehicle at the lease residual value when the lease ends. If the car is worth substantially more than the lease residual value, the lessee will likely buy the car at the lease residual value and keep it or resell it at the higher actual market value. Thus, finance companies bear considerable downside risk with respect to residual value, but obtain little benefit from residual values which are far above expected.
Accounting Problems
Leasing companies also have a second problem with leasing which does not occur with traditional financing. Payments on traditional financing are accounted for as receivables. However, on lease financing, the lessee has not contracted to pay the residual value at the end of the lease. The lessee can simply return the car to the finance company in good condition. For this reason, the estimated residual value of the lease is not accounted for as a receivable.
Most finance companies are borrowing the money required to create leases. The finance company is paying cash to the dealer for the entire price of the car, but only has a receivable for the lease payments. Depending on the model and length of the lease, the residual value might be 30-80% of the purchase price of the car. Unless something is done with the leases, a leasing company will accumulate a large amount of volatile residual values as assets and a large amount of liabilities related to the money the finance company borrowed to buy the vehicles which were leased.
Securitizing Lease Payments
Many prior attempts to reduce residual value risks involve moving the ownership of the automobiles to other entities. Many finance companies bundle together large portfolios of automobile leases and create new securities from them. The process is similar to the method which Fannie Mae uses to bundle together large numbers of home mortgages to create a mortgage-backed security. With automobile leases, the process is referred to as lease securitization. Securitizing leases allows the finance company to remove large numbers of leases from their books and use the proceeds to initiate new leases. However, the uncertainty of residual values for the leases involved can create accounting problems and problems with selling the lease-backed security.
A retitling problem is also associated with automobile lease securitization. Purchasers of a lease-backed security generally prefer a security which is insulated from potential bankruptcy of the issuer. If the finance company has not planned in advance, this will take considerable effort to create. Unlike most other assets, an automobile can only be transferred if the owner, in this case the leasing company, signs the back of the certificate of title and certifies the odometer reading. After this step the new owner (in this case, the owner of the lease-backed security) applies for a new certificate of title in its own name. This would normally need to be done for every auto which is to be included in a lease-backed security and, therefore, imposes a significant administrative burden on purchasers of such lease-backed securities.
A common method of insulating purchasers of lease-backed securities from issuer bankruptcy and reducing administration is the creation of a titling trust. Title for leased vehicles is placed with the titling trust from the time of sale. The securitization is then accomplished by selling xe2x80x9cbeneficial interestsxe2x80x9d in the titling trust. The finance company services all of the leases from the trust and receives a servicing fee. Such trusts are usually limited partnerships insulated from the finance company""s potential bankruptcy, however, they have their own administrative burdens.
In lease securitization, Generally Accepted Accounting Principles (xe2x80x9cGAAPxe2x80x9d) accounting treatment is quite different from income tax accounting. Under bankruptcy rules and for GAAP accounting purposes, a lease securitization is typically treated as a sale. With care, many of these same securitizations are not treated as sales for income tax purposes. This allows the finance company to take depreciation on the vehicles each year.
Residual Value Protection
If a finance company wishes to securitize a group of leases, the potential purchasers and rating agencies will be concerned about residual value risk. If the finance company overestimates residual value, the lease-backed security may not be able to pay off its full interest and principal obligations. Three conventional approaches to reducing the residual value risk for purchasers of lease-backed securities are discussed below. See also, Stuart M. Litwin, xe2x80x9cUnlocking the Mysteries of Auto Lease Securitizationxe2x80x9d, Business Credit, September 1996, p. 28-30, incorporated herein by reference.
1. Purchasing residual value insurance from insurance companies. Although purchasing residual value insurance may seem to be a fairly straightforward approach to reducing the residual value risk, it suffers from problems with both capacity and counterparty risk. With regard to capacity, a major problem with residual value insurance is that the total amount of residual values for leases is huge. Total residual values for auto leases in the U.S. exceed $150 billion. See, Ward""s 1999 Automotive Yearbook, incorporated herein by reference. Overestimates of 10% or more on a portfolio of leases has happened to some lenders in recent years. If most leases were covered by residual value insurance, a significant downturn in the used car market could create insured losses larger than Hurricane Andrew and the Northridge Earthquake combined ($15.5 billion and $15.3 billion, respectively). Losses of this magnitude would cause substantial insolvencies in the insurance industry.
Residual value insurance policies have typically been sold by a few small specialty insurance companies and the risk is unusually concentrated. Because of the limited capacity of residual value insurers, finance companies have found it difficult to purchase very large amounts of pure residual value insurance. Thus, many finance companies avoid purchasing residual value insurance due to the counterparty risk of these insurance companies.
2. Residual value guarantees from the finance company issuing the lease-backed security. The finance company itself can provide a specific amount of residual value guarantee for a particular securitization. This approach can work for finance companies which already have good credit ratings. With residual value guarantees, however, the finance company retains large amounts of residual risk, and many of the factors affecting the risk are beyond the finance company""s control. Securitizing in this manner provides new cash to the finance company, but no relief from residual value risk. In fact, repeating this process tends to increase residual value risk: the finance company gets fresh supplies of cash and creates new leases with new residual value risk. In at least one case, the residual value retained by the auto finance unit was separately turned into a bond. See, Adam Reinebach, xe2x80x9cToyota Sells Rare Residual Value Securitizationxe2x80x9d, Investment Dealers Digest, Aug. 10, 1998, p. 5, incorporated herein by reference. This transaction has been compared to issuing a catastrophe bond. Securitizing residual values separately requires significant amounts of analysis and credibility. Such bonds would need to be issued regularly to be a primary source of relief for residual value risk and are impractical for many issuers.
3. A segregated reserve account. In this case, the finance company establishes a cash fund from the proceeds of the securitization to cover a certain amount of potential shortfall from the residual values. The finance company is only at risk of losing this cash fund; any losses larger than the cash fund are borne by the lease-backed security purchasers. In some cases, there are provisions which allow the cash fund to be increased under certain circumstances. In other cases, there is some residual value insurance which attaches after the cash fund is exhausted. The primary problem with this approach is satisfying rating agencies and potential bondholders that the cash fund is sufficient for a low risk bond and a correspondingly low interest rate. The analysis required for issuing bonds with this type of guarantee is very extensive.
Other Index Futures and Options
The vast majority of futures and options traded on organized exchanges are based on one of the following: stock price, bond price, metal price, energy price, agricultural commodity price, exchange rate, stock index value, or bond index value. In the vast majority of cases, the underlyer can be purchased in the open market. However, there are several exceptions on the futures markets.
Catastrophe futures and options are traded on the Chicago Board of Trade. These are based on indexes of insured catastrophe losses occurring in the United States. Catastrophe futures are based on a liability index, rather than the typical asset price for futures.
The Bankruptcy Index is now traded on the Chicago Mercantile Exchange. This contract is based on an index of the number of consumer bankruptcy filings. Bankruptcy Index futures and options are based on an index which correlates with a liability: bankruptcy and dollars of consumer credit bad debt.
Heating Degree Day contracts are also traded on the Chicago Mercantile Exchange for several cities. These contracts correlate with energy demand and energy prices. These have no underlying asset or liability.
Presently, there are no known exchange-traded futures based on baskets of manufactured goods. See, Commodity Futures Trading Commission, xe2x80x9cFutures and Options Contracts Designated by the Commodity Futures Trading Commission as of Sep. 30, 1998xe2x80x9d, September 1998, http://www.cftc.gov/annualreport98/contractsdesig.htm. Also, there are no known bond issues which have detachable exchange-traded futures or options.
In view of the foregoing, there is clearly a need for a method of creating an index of residual values for leased vehicles and of transferring residual value risk and creating lease securitizations such as futures, options and insurance products in consideration of the index of residual values.
Accordingly, it is an object of the present invention to provide a method for transferring residual value risk in a manner which is efficient and minimizes counterparty risk using futures and options.
It is another object of the present invention to provide a method for calculating a Residual Value Index which is useful for creating and pricing such futures and options.
It is another object to reduce the risk of insurer insolvency.
It is another object to provide substantial additional capacity for transfer of residual value risk.
It is another object to allow the creation of new insurance products which are made possible by residual value futures and options.
It is another object provide a system and method for performing certain calculations in valuing such futures and options.
It is another object to provide residual value hedging mechanisms which do not require large up front outlays of cash.
It is another object to generalize the approach from residual value to futures and options traded on any reliable index of assets which depreciate over time created by an independent party.
It is another object to generalize the approach from residual value to futures and options traded on any reliable index of value of manufactured goods created by an independent party.
It is another object to generalize the approach from residual value to futures and options traded on any reliable index of value of durable goods created by an independent party.
An exemplary preferred method according to the present invention includes one or more of the following steps: calculating a residual value index for all automobiles and light trucks sold during a particular period of time; calculating various residual value subindexes; creating exchange-traded residual value futures; creating exchange-traded residual value options; creating over the counter residual value futures; creating over the counter residual value options; creating new residual value insurance products; and using such futures, options and insurance to create new types of lease securitizations.
According to an exemplary preferred method of the present invention, residual values futures and options are created in consideration of an independent residual value (xe2x80x9cRVxe2x80x9d) index for actual prices of lease returns. This is the underlying index on which the futures are calculated. An exemplary preferred index takes a third party source of actual residual values for automobiles of a given model and model year and weights the distribution between models to match the initial percentages of those models sold during that model year.
The principles of the present invention can be employed for other indexes, such as aircraft residual value indexes, and for aircraft residual value futures, options and insurance.
The principles of the present invention can also be employed for futures, options and insurance on the value of durable goods, manufactured goods, or an asset which depreciates over time.
Additionally, the principles of the present invention can be employed to provide new bond issues and lease securitizations which make use of the aforementioned futures and options.
In accordance with another embodiment of the present invention, a method of transferring residual value risk associated with future market value of goods includes the step of: determining terms of a contract pertaining to a residual value risk associated with a future market value of goods in consideration of an index of residual value for two or more types of goods.
In accordance with another embodiment of the present invention, a method of transferring residual value risk using exchange traded futures or options includes the step of: creating a lease securitization where residual value risk is mitigated using exchange traded futures or options.
In accordance with another embodiment of the present invention, a method of transferring residual value risk using exchange traded futures or options includes the step of: making a payment on a lease securitization where residual value risk is mitigated using exchange traded futures or options.
In accordance with another embodiment of the present invention, a method of creating a residual value index includes the steps of: identifying a plurality of assets of different types to be included in a residual value index; determining an initial market valuation for the assets; determining a starting value for the residual value index in consideration of the initial market valuation; at a later time, determining a subsequent market valuation for the assets; and determining a subsequent value for the residual value index in consideration of the subsequent market valuation.
In accordance with another embodiment of the present invention, a method of generating a time series of indexes or subindexes includes the steps of: creating new indexes of value at regular time intervals; and applying weightings to two or more items in the indexes.
In accordance with another embodiment of the present invention, exchange traded futures or options include: an exchange traded futures or options contract including terms which are determined in consideration of at least one underlying index of value within a master index, the master index including two or more series of similar indexes of value and new indexes of values for the series which commence trading at future points in time.
In accordance with another embodiment of the present invention, a method of qualifying futures or options for trading on an exchange includes the step of: obtaining approval from a regulatory body or entity for trading futures or options contracts on an exchange, the futures or options contracts including terms which are determined in consideration of at least one underlying index of value within a master index, the master index including two or more series of similar indexes of value and new indexes of values for the series which commence trading at future points in time.
In accordance with another embodiment of the present invention, a method of transferring residual value risk includes the step of: entering into, purchasing or selling an exchange traded futures or options contract including terms which are determined in consideration of at least one underlying index of value within a master index, the master index including two or more series of similar indexes of value and new indexes of values for the series which commence trading at future points in time.
In accordance with another embodiment of the present invention, over the counter futures or options including: an over the counter futures or options contract including terms which are determined in consideration of at least one underlying index of value within a master index, the master index including two or more series of similar indexes of value and new indexes of values for the series which commence trading at future points in time.
In accordance with another embodiment of the present invention, a method of transferring residual value risk includes the step of: entering into, purchasing or selling an over the counter futures or options contract including terms which are determined in consideration of at least one underlying index of value within a master index, the master index including two or more series of similar indexes of value and new indexes of values for the series which commence trading at future points in time.
In accordance with another embodiment of the present invention, a method of issuing a bond with a detachable security includes the steps of: choosing one or more preexisting exchange traded securities in consideration of a riskiness of a bond to be issued; purchasing the exchange traded securities; and issuing one or more detachable contracts in conjunction with the bond, the detachable contracts being related to the exchange traded securities which were purchased.
A. Calculating the index. An exemplary preferred residual value index according to the resent invention is similar in some respects to an index of multiple stock values, such as the SandP 500 index, and is calculated as follows:
1. The assets which will be included in the index are agreed upon. For the SandP 500 index, these are the 500 publicly traded companies which will become part of the index. For the residual value index, these are the make, model, model year, etc. For the master U.S. residual value index, the index would include all cars and light trucks sold in the U.S. in a particular model year. Similar indexes can be created for other countries or groups of countries.
2. For each different model of car, the market value per unit from an agreed source is multiplied by the number of units sold. These calculations produce a market valuation for that model of automobile. This is similar to the SandP 500 index using a market value weighting for components of the SandP 500.
3. To calculate the starting value for each index, the market values as of the start date are added together for all models in the index. This number is used as a basis for future comparison. The initial number can have some physical significance, such as the average price per car, or can be indexed to an even starting number, such as 100.
4. At later points in time, the index is recalculated with new market values for each model. For the Residual Value Index, the new values are the wholesale prices of each model used car from the third party source. This is similar to recalculating the SandP 500 index with current closing prices of stocks included in the index.
5. Unlike the SandP 500 index, a new Residual Value Index (xe2x80x9cRVIxe2x80x9d) is created for each model year. Thus, there will be a 2000 RVI, a 2001 RVI, a 2002 RVI, etc. Since each RVI tracks the current values of a particular cross section of cars from a particular model year, there will be a number of RVIs valued at the same date. Moreover, RVIs can be calculated for any past model year for which reliable data is available, e.g., a 1977 RVI calculated as of the year 2000.
6. Just as the SandP 500 index has technology, utility and agricultural components, the RVI index can have related indexes and subindexes. Examples include: pickup trucks, sedans, Ford automobiles, eight cylinder automobiles, blue cars, red cars, convertibles, luxury cars, cars with initial prices over $30,000, cars leased through Toyota Motor Credit, and cars sold in California. Since the master RV database includes all models and submodels which are sold in a particular time period, the creation and updating of subindexes (e.g., pickup truck index, Ford index) requires very little effort. All of the necessary data is already collected and present in the database.
B. Creation of Futures, Options and Insurance Products. Once an index or subindex is agreed upon and calculated, a variety of financial products using the index can be created. For example:
1. A standard contract can be developed for exchange-traded index futures based off of the RVI.
2. Options on these futures can also be developed.
3. Over the counter futures and options can also be developed.
4. A variety of hedging strategies can be developed by companies which currently retain residual value risk. This would include both finance companies and insurance companies who have residual value guarantee programs in place.
5. New choices are provided for leasing companies who desire to securitize groups of leases through bond issues or private placements.
6. Insurance products which relate to the residual value of leases held or originated by a particular company can be designed or modified to make use of the new indexes.